Much has been written recently on whether the era of the 60/40 portfolio has ended. With the MSCI World index of global equities falling 20.5 per cent in the first six months of the year1 – the worst performance on record – and aggregate bonds down over 8.5 per cent in Sterling-hedged terms (Barclays Global Aggregate),2 strategies that rely heavily on combining these assets have seen little diversification benefit.
Two elements have led to rising volatility in balanced portfolios: a rise in bond volatility; and a move in correlations between bonds and equities. Correlations have gone from being generally negative over the last 15 years to becoming neutral and occasionally positive in recent months as large parts of the equity market reacted badly to rising interest rates.
The conditions that have led to this are likely to persist.
Economic growth is solid but still slowing compared to late 2020 and early 2021. That will limit the scope for strong gains and low volatility in the equity market. And, even though we are likely passing the peak of reported year-on-year inflation, pressures remain sustained, and inflation will probably take time to come down. Central banks will have to keep an eye on it for at least another 12 months. This combination will continue to challenge balanced portfolios.
Despite the recent volatility and spike in yields, we still see a long-term structural role for bonds, particularly government bonds, in multi-asset portfolios.
While our central case outlook suggests government bond returns will be challenged, we build portfolios with multiple alternative outcomes in mind. Most investors are familiar with the scenario in which government bonds are the only game in town: a period of recession accompanied by disinflation, likely combined with interest rate cuts. This path can never be ruled out entirely – indeed, we have recently seen this debate return to markets, along with some respite for bond returns. The historical frequency of recessions also suggests most forecasters will miss a looming downturn around ten per cent of the time. If only for that possibility, it makes sense to continue including government bonds in well-diversified portfolios.
In addition, sensitivity to valuations can improve the risk-reward balance. Where attractive opportunities arise, we can increase our exposure. Developed-market bonds, which had been offering zero or even negative yields in some cases, are now starting to offer more attractive yields. Good value is not yet widespread, but we are a lot closer to sensible valuations than we were last year. Ten-year Gilts, for example, yielded just 0.65 per cent a year ago and now offer in excess of two per cent.3
Figure 1: Ten-year gilt yields, January 2021 to July 2022
Source: Bloomberg. Data as of July 13, 2022
We are also seeing opportunities emerge in other parts of fixed income. For instance, after holding reduced positions in corporate and high-yield bonds for much of the last year, we recently started to rebuild exposure after a sharp increase in yields resulted in better compensation for inflation and interest-rate risks. As an example, yields in the Bloomberg Barclays Global High Yield Index went from 4.12 per cent on June 7, 2021 to 9.47 per cent on July 6, 2022.4
Figure 2: Global high-yield yields, January 2021 to July 2022
Source: Bloomberg Barclays Global High Yield Index, Bloomberg. Data as of July 13, 2022
For those two reasons, we continue to take a close interest in bond markets. However, where we see concentration risk, particularly in cautious portfolios, it is important to be well diversified – by using alternatives or cash alongside fixed-income allocations to balance equities, for example.
In our active multi-asset ranges, we manage asset allocation dynamically. And despite sharp rises in the first half of the year, yields could go higher still. In addition, with central banks likely to remain quite active this year, it is going to be hard for investors to identify the peak in rates with any confidence. Our central case is yields will continue to rise and we are therefore underweight bonds in portfolios where we have discretion, generally favouring cash, which offers us the flexibility to add to bonds as opportunities arise.
As always, it helps to have a long-term investment strategy. The main driver of long-term wealth creation is the return on growth assets such as equities and credit. Periods of volatility, and even sustained downturns, are a part of having equity-market exposure, even if bonds do not continue to mitigate that volatility to the same extent as they have in previous years. They do not constitute a reason to rethink the entire long-term approach – including 60/40 strategies.
Clients with a low risk-appetite – and therefore invested in lower-risk multi-asset funds – may feel concerned. These funds are sometimes heavily weighted towards fixed income, which makes things difficult in periods of rising volatility and declining bond prices. In this scenario, the adviser may prefer to find funds that target low volatility in a more diversified manner, avoiding concentration in any particular fixed-income market and, where possible, complementing these holdings with alternatives or cash.